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Contrarians are bullish

Commentary: Slope of hope has given way to strong wall of worry

CHAPEL HILL, N.C. (MarketWatch) — The sentiment stars are aligned nicely in favor of the stock market’s rally continuing at least a while longer.

That’s because, despite an impressive rally over the last two weeks, the average adviser remains profoundly skeptical that the advance will continue. That’s a bullish sign, according to contrarian analysis.

Consider the average recommended equity exposure among the short-term market timers tracked by the Hulbert Financial Digest (as measured by the Hulbert Stock Newsletter Sentiment Index, or HSNSI). On Aug. 10, the day of this summer’s closing low, this average stood at minus 16.6%, which meant that the average short-term timer was at that time recommending to clients to allocate a sixth of their equity portfolios to going short.

Despite a rally that has seen the Dow Jones Industrial Average
DJIA, -0.05%
gain 7.6% and the S&P 500 index
SPX, +0.01%
gain 8.0%, the HSNSI has risen only slightly — and still remains below 0. In fact, its latest reading is minus 7.5%, only 9.1 percentage points higher than at the Aug. 10 closing low.

Indeed, the HSNSI is currently at precisely the same level it was on Aug. 19, when I last devoted a column to a contrarian analysis of the market — even though the Dow is 5% higher now than then. This refusal to become more bullish on the part of the average short-term market timer has led me to change my mind about what the sentiment data are saying. (Read my Aug. 19 column.)

One of the reasons I changed my mind was an econometric analysis I conducted of how much of an increase in the HSNSI we should have expected, given a Dow gain of 7.6% over 13 trading sessions (which is the number of trading days from the Aug. 10 low through Monday’s close). Based on a regression analysis of the last decade’s values for my sentiment index, we would have otherwise expected the HSNSI to have risen by 49 percentage points — or five times greater than what we actually have seen.

This marked spread between the actual HSNSI increase and what we would otherwise have expected is an indication of just how skeptical the market timing community is of this rally. It is almost the mirror opposite of the sentiment situation that prevailed earlier this year when, despite a marked decline in the market, the HSNSI remained stubbornly high.

To put the contrast from before another way: Instead of the slope of hope that prevailed then, we now have a wall of worry.

Unfortunately, contrarian analysis offers little guidance on how much longer the rally will last, or how much higher the market will go. The key to the rally’s longevity, from a sentiment point of view, will be how the market timers react in coming days and weeks.

If they continue to be stubbornly bearish in the face of the rally, then contrarians would expect the rally to keep going. If, in contrast, the market timers quickly jump on the bullish bandwagon in coming sessions, then the rally would quickly lose contrarian support.

Anything’s possible, of course, in this fast-paced market.

For the moment, however, it certainly looks as though the breathtaking market drops earlier this month, coupled with the extraordinary subsequent volatility, have created a wall of worry that is robust enough to not crumble anytime soon.

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